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An integrated financial amplifier: the role of defaulted loans and occasionally binding constraints in output fluctuations

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  • José R. Maria
  • Paulo Júlio

Abstract

We present a DSGE model for a small euro area economy comprising a banking sector empowered with regulatory capital requirements, defaulted loans and occasionally binding endogenous credit restrictions. Under non-financial shocks no important amplifications arise due to balancing forces: while banks' equity acts as a shock absorber, the observance of regulatory capital requirements acts as a shock amplifier. Under moderately-sized "bad" financial-based shocks defaulted loans increase and banks' value drop. As a result, credit becomes supply constraint for some time, severely amplifying and protracting output downfalls. Endogenous inertia implies a slow recovery in banks' capital and thus an enduring fragility of the banking system. Defaulted loans and credit restrictions are strongly intertwined, since the former severely impact banks' value, hence leveraging the amplification size.

Suggested Citation

  • José R. Maria & Paulo Júlio, 2018. "An integrated financial amplifier: the role of defaulted loans and occasionally binding constraints in output fluctuations," Working Papers w201813, Banco de Portugal, Economics and Research Department.
    • Handle: RePEc:ptu:wpaper:w201813
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    More about this item

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • H62 - Public Economics - - National Budget, Deficit, and Debt - - - Deficit; Surplus

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